What is the denomination effect?

They say that if you take care of the pennies then the pounds (or euros or dollars) will take care of themselves.

But the way we view money tends to fly in the face of this advice: the smaller the currency, the more likely we are spend it, researchers have found.

Psychologists who gave people the same amount of money as either a single, large bill or as several smaller denomination bills found that that those given the larger denominations were much more likely to hang on to their cash than the others.

This form of cognitive bias has been labelled the “denomination effect” by researchers Priya Raghubir from New York University and Joydeep Srivastava from the University of Maryland.

The effect occurs because large denominations are regarded as less fungible – that is, psychologically less replaceable with equivalent notes – than smaller denominations, the researchers said.

Mental accounting
They relate their findings to the concept of mental accounting, explaining that “a large denomination of money may be placed into a mental account of ‘real money’, whereas an equivalent amount in smaller denominations may be placed in a ‘petty cash’ or ‘loose change’ account”.

To investigate their theory, Raghubir and Srivastava gave participants one dollar either as a single bill or four quarters and told them they were free to spend it or save it. Those given the quarters were significantly more likely to spend it than those with the single bill.

To make sure that it wasn’t just that people didn’t like carrying loose change, the researchers then compared how people spent $5 when awarded as a single note or as five $1 dollar bills. Again, those with the $1 bills were more likely to spend the money than those with the $5 notes.

For their third experiment, the researchers tested what happened when much larger sums of money were involved.

They gave a group of women in China RMB 100 as either a single note or in the form of five notes; considering the majority of the group earned between RMB 301 and 600 per month, this represented a large proportion of their monthly income.

After being told they could either keep the money or spend it on soap, shampoo, bedding or pots and pans, those who had the five notes were more than twice as likely to spend the money compared to the single-note recipients.

Commitment device
A subsequent study by Raghubir and Srivastava showed that people who needed to exert self-control and save $100 preferred to be paid in a single large denomination, whereas those who didn’t need to save preferred the smaller notes.

In this way, a large-domination note acts as a type of commitment device: a self-imposed arrangement that helps a person deal with the want/should conflict and stick to their pledge, like putting credit cards in a block of ice, or setting up a direct debit into a restricted-access savings account.

The denomination effect isn’t the only factor that affects how quickly we spend our money, though.

Researchers have found that the physical condition of money has a big influence too: we tend to spend old, dirty notes much faster than fresh, crisp ones.

The academics said that people like to get rid of worn currency because they are disgusted by the contamination from others. In contrast they actively hang on to fresh notes, which appeal to their sense of pride.

“This suggests that the physical appearance of money matters more than traditionally thought, and like most things in life, it too is inextricably linked to the social context,” they concluded.